Saturday, October 17, 2015

The Closing Bell

The Closing Bell


Statistical Summary

   Current Economic Forecast

                        Real Growth in Gross Domestic Product                       +2.6
                        Inflation (revised)                                                           +0.1%
                        Corporate Profits                                                             +3.7%

            2015 estimates

Real Growth in Gross Domestic Product (revised)      -1.0-+2.0%
                        Inflation (revised)                                                          1.0-2.0%
                        Corporate Profits (revised)                                            -7-+5%

   Current Market Forecast
            Dow Jones Industrial Average

                                    Current Trend (revised):  
                                    Short Term Downtrend                            17076-17792
Intermediate Term Trading Range           15842-18295
Long Term Uptrend                                  5369-19241
                        2014    Year End Fair Value                             11800-12000                                          
                        2015    Year End Fair Value                                   12200-12400

                        2016     Year End Fair Value                                   12600-12800

            Standard & Poor’s 500

                                    Current Trend (revised):
                                    Short Term Downtrend                                1986-2048
                                    Intermediate Term Uptrend                        1936-2728
                                    Long Term Uptrend                                    797-2145
                        2014   Year End Fair Value                                     1470-1490

                        2015   Year End Fair Value                                      1515-1535
                        2016 Year End Fair Value                                      1560-1580          

Percentage Cash in Our Portfolios

Dividend Growth Portfolio                          53%
            High Yield Portfolio                                     54%
            Aggressive Growth Portfolio                        53%

The economy provides no upward bias to equity valuations.   The dataflow this week was mixed, with no bias in either direction.  Given the negative trend of the last six weeks, a neutral week of data in and of itself is a positive: above estimates: weekly jobless claims, month to date retail chain store sales, September small business optimism index, October consumer sentiment, September CPI, ex food and energy, September industrial production; below estimates: September retail sales, August business inventories/sales, October NY and Philly Fed manufacturing indices, the September US budget deficit, September PPI; in line with estimates: weekly mortgage and purchase applications, September CPI.

The primary indicators included September industrial production (+) and September retail sales (-).  So here too the numbers were evenly matched.

However, tilting the overall balance to the negative side were several anecdotal developments: (1) Walmart slashed its earnings guidance, supporting the aforementioned poor retail sales numbers (2) Delta’s CEO said that there was a worldwide glut of wide bodied aircraft [Boeing]---yet another example of the misallocation of assets fostered by zero interest rates, (3) Illinois delayed pension payments, citing liquidity problems.

Overseas, the data flow remained lousy. 

The Fed released its latest Beige Book report this week.  The tone was less optimistic than recent predecessors which was not that surprising given the recent stream of discouraging data.  That was followed the next day by a WSJ article by Fed mouthpiece Hilsenrath suggesting that a rate hike in 2015 was now off the table.  Putting a cherry on top, on Thursday, it seemed like every central banker in the world was talking up more QE.  And why not?  These clowns are deeply invested in QE working; and since it has not, it must be because there was not enough of it.  So, gentlemen, start your printing presses.

I have lowered our 2015 economic forecast again (see above).  The key numbers are (1) GDP growth which now incorporates the possibility of negative growth [i.e. recession] and (2) lower corporate profits.

In summary, the economic stats both here and abroad remained sub-par while the Fed is scrambling to hold off the ultimate price that will be paid for its ill-conceived policies. 

Our forecast:

a much below average secular rate of recovery, exacerbated by a declining cyclical pattern of growth with an increasing chance of a recession resulting from too much government spending, too much government debt to service, too much government regulation, a financial system with conflicting profit incentives and a business community hesitant to hire and invest because the aforementioned, the weakening in the global economic outlook, along with the historic inability of the Fed to properly time the reversal of a vastly over expansive monetary policy.
       The negatives:

(1)   a vulnerable global banking system.  Nothing much occurred this week in the US, save the quarterly bank current earnings reports which were mixed. 

However, a Hong Kong based research firm said that Chinese banks’ nonperforming loan ratio is six times higher than reported---the importance of which is the higher risk of a major Chinese bank failure.

On the other hand, the UK seems to be following in the US’s footsteps in forcing the big banks to separate out their investment banking operations.

 ‘My concern here.....that: [a] investors ultimately lose confidence in our financial institutions and refuse to invest in America and [b] the recent scandals are simply signs that our banks are not as sound and well managed as we have been led to believe and, hence, are highly vulnerable to future shocks, particularly in the international financial system.’

(2)   fiscal/regulatory policy.  No mischief this week.

(3)   the potential negative impact of central bank money printing:  The key point here is that [a] the Fed has inflated bank reserves far beyond any comparable level in history and [b] while this hasn’t been an economic problem to date, {i} it still has to withdraw all those reserves from the system without creating any disruptions---a task that I regularly point out it has proven inept at in the past and {ii} it has created or is creating asset bubbles in the stock market as well as in the auto, student and mortgage loan markets.  

It would seem that the Fed [and regrettably the economy] is in a massive negative feedback loop---the worse the economy gets, the easier the Fed policy which begets additional worsening in the economy which……..well you get the picture.  So why does an easy Fed not lead to a better economy?  Because the money is not being used for savings/investment, it is being used to speculate/chase yield.  And the Market’s reaction to every news item announcing more QE is a testimony to that fact.

Debt fueled buybacks now eating into earnings (medium and a must read):

Plus, are debt markets near full capacity (medium):

My thesis remains:

[a] QE {except QEI} has had little impact on the economy; so unwinding it will have an equally small effect on the economy,

[b] however, QE led to significant asset mispricing and misallocation; unwinding it will have an equally significant effect on asset prices,

[c] in any case, the Fed has once again waited too long to begin the process on monetary normalization.  That will compound their asset mispricing problem if the Markets decide to take matters into their own hands and they will be less circumspect in correcting the pricing problem,

[d] the Fed knows that it has made a mistake, but appears to think that its only alternative is to bulls**t the Markets and pray for luck.  The danger here is that in a desperate attempt to extricate itself from the problem, it may make another equally disastrous misjudgment and only make matters worse.

You know my bottom line: sooner or later, the price will be paid for asset mispricing and misallocation.  The longer it takes and the greater the magnitude of QE, the more the pain.
(4)   geopolitical risks: Syria was front and center this week as [a] Russia and Iran sent in more men and material and [b] Russia continued its aggressive bombing campaign against rebels.  I am not worried about who is killing who in this war.  As far as I am concerned, the US is a net winner in any case.

 I am concerned about the possibility of ‘shots fired’ between US and Russian forces whether accidental or not---for obvious reasons.  I am also uneasy about the continuing erosion of respect accorded to the US.  Weakness is not a quality admired by our major adversaries and could lead them to pursue even more aggressive anti-US policies. 

Given the cluelessness of our current foreign policy, the risks exist of either [a] further humiliation which will be difficult for the next administration to walk back or [b] an inappropriate US response in an attempt to prove it has cojones.  While I have no idea about the odds of either transpiring, they are not zero and that makes me a bit nervous.

(5)   economic difficulties, overly indebted sovereigns and overleveraged banks in Europe and around the globe.  This week’s overseas economic stats included: terrible Chinese trade and inflation data, even worse Indian trade stats, lowered expectations for Russian GDP growth, declining UK inflation, poor German economic morale and Brazil’s credit rating being downgraded by Fitch.  In addition, there was a report that the Chinese banks are much more leverage than is currently assumed.  The only bright spot was UK employment and forecast 2015 GDP growth.

Of course, in the ivory tower world of central banking, the reflex action to weak data is more QE.  And as I noted above, there were no disappointments---the apparent working assumption being that if a whole of lot QE didn’t work, then doubling down must be the answer.

In sum, the international economic news was lousy, so the monetary spigots will likely be opened wider---enabling the central bankers to push the misallocation and pricing of assets to its logical conclusion.   This combo keeps the yellow flashing on our global ‘muddling through’ assumption; a flashing red light is not that far away.

       Global trade in six charts (short):

Bottom line:  the US data continues to reflect very sluggish growth in the economy.  In addition, global economic trends are still deteriorating; and the Fed remains paralyzed by fear of the consequences of prior policy mistakes.  As a result, I have lowered our economic forecast again; and I may have to do so again.  A deteriorating global economy and a counterproductive central bank monetary policy are the biggest economic risks to our forecast. 

This week’s data:

(1)                                  housing: weekly mortgage and purchase applications fell but that was largely a reversal from last week’s accounting impacted up move,

(2)                                  consumer: weekly jobless claims fell more than expected; month to date retail chain store sales improved from the prior week; September retail sales were in line, but ex autos they were less than anticipated; October consumer sentiment was stronger than projected,

(3)                                  industry: September small business optimism index slightly better than estimates; August business inventories were flat but sales fell; September industrial production was down less than estimates; October NY and Philadelphia Fed manufacturing indices were below consensus,

(4)                                  macroeconomic: September PPI and PPI, ex food and energy were below forecasts; September CPI was in line, ex food and energy were above expectations; the September US budget surplus was less than anticipated.

The Market-Disciplined Investing

The indices (DJIA 17215, S&P 2033) blew through their September highs on their second attempt; though to date little else has changed in the technicals.  The Dow ended [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] in a short term downtrend {17076-17792}, [c] in an intermediate term trading range {15842-18295}and [d] in a long term uptrend {5369-19175}.

The S&P finished [a] below its 100 and 200 day moving averages, both of which represent resistance, [b] below the upper boundary of a very short term downtrend, [c] in a short term downtrend {1986-2048}, [d] in an intermediate term uptrend {1936-2728} [e] a long term uptrend {797-2145}.  However, it is nearing its 100 day moving average and the upper boundary of its short term downtrend.  Clearly, a successful challenge of those barriers will lift a heavy lid off the Market.

Volume increased; breadth was mixed.  The VIX (15.0) was off 6%, finishing [a] back below its 100 day moving average, which I am now calling resistance, [b] within a short term downtrend and [c] in intermediate term and long term trading ranges.  A return to the 12-13 zone would again represent an opportunity to buy cheap portfolio insurance.
The long Treasury was up, ending above its 100 day moving average, still support; and within very short term, short term and intermediate term trading ranges. 

GLD declined, but still closed [a] above its 100 day moving average, now support [b] above the upper boundary of its a short term trading range for the third day, re-setting to an uptrend, [c] back below the upper boundary of its intermediate term downtrend, voiding Wednesday’s break; clearly a disappointment for the gold bulls and a hitch in calling a bottom on gold and [d] within a long term downtrend. 

The dollar rose back above the lower boundary of its short term trading range, negating Thursday’s break.  It remained below its 100 day moving average and within an intermediate term trading range.

Bottom line: stocks pushed back into overbought territory on Friday; although that has not counted for a lot in the last two weeks of trading.  In addition, the indices broke through their September highs.  If they hold, that should provide additional upside momentum and raise the odds further that they will challenge their all-time highs.  This might be a good set up for a nimble trader; however, given the fundamentals and disparity between current prices and our Fair Values, it is not a place for investors (like me).

Gold’s retreat back below the upper boundary of its intermediate term downtrend lessened the impact of its break above its 100 day moving average earlier in the week and Friday’s re-set of its short term trend to up.  Certainly, GLD can challenge its intermediate term trend again; but for the moment, it dampens this last week’s strong upward momentum.

Fundamental-A Dividend Growth Investment Strategy

The DJIA (17215) finished this week about 40.7% above Fair Value (12234) while the S&P (2033) closed 34.0% overvalued (1517).  Incorporated in that ‘Fair Value’ judgment is some sort of half assed attempt at getting fiscal policy under control, a botched Fed transition from easy to tight money, a historically low long term secular growth rate of the economy and a ‘muddle through’ scenario in Europe, Japan and China.

The US economic data continues to weaken.  Plus, as I noted above, there were a number discouraging anecdotal events this week; and the global economy may be in worse shape than the US.  Accordingly, this week, I lowered our forecast for the second time this year, in which I incorporated the possibility of a recession.  Unfortunately, if the numbers continue to be lousy, the odds of a negative GDP report will grow.

In sum, the US and global economies are weak and getting weaker.  The risk here is that many Street forecasts are too optimistic; and if they are revised down, it will likely be accompanied by lower Valuation estimates.

This week, the consensus is that the Fed will remain easy.  Contributing to this notion was (1) the tone of the latest Beige Book which was less upbeat than those of the recent past and (2) an article by John Hilsenrath basically saying the a rate hike was off the table for 2015.  Neither of these come as a surprise given the recent dataflow. 

Unfortunately, the Fed won’t stay accommodative because of the economy; it will do so to keep the Markets happy.  And of course, that is part of the problem---saying one thing (data dependent) and acting another (talking QE when Markets decline).  For reasons I can’t fathom, the Market is buying that routine for the moment.  But that can’t go on forever because at some point either (1) QE will continue ineffective and the economy will fall into recession and corporate profits will get whacked neither of which are looked on with favor by the Markets or (2) valuations get driven to such absurd levels that no one will be willing to buy because there is zero return priced into stocks.

And to be clear, I don’t believe that there is any warm and fuzzy third alternative.  The cold, hard facts, as I see them, are that the Fed (1) has pursued a policy that has created another asset bubble, (2) it has waited too long to attempt to correct that mistake, and (3) its only choices are to do the right thing [i.e. return to a normalized monetary policy], which will be painful, or to continue to pursue a disastrous strategy hoping and praying for a miraculous way out, which I believe will end even more painfully when hope and prayer prove an empty strategy.

That said, I have no idea at what point investors figure out this no win equation; although if economic conditions continue to worsen, option (1) may not be that far off.  However, whenever and whatever happens, I believe that the cash generated by following our Price Discipline will be welcome when investors wake up because I suspect the results will not be pretty. 

Net, net, my two biggest concerns for the Markets are (1) the economic effects of a slowing global economy and (2) Fed [central bank] policy actions whatever they are or are not and the loss of confidence in those actions.

Bottom line: the assumptions in our Economic Model are unchanged.  If they are anywhere near correct, they will almost assuredly result in changes in Street models that will have to take their consensus Fair Value down for equities.  Unfortunately, our assumptions may be too optimistic, making matters worse.

The assumptions in our Valuation Model have not changed either; though at this moment, there appears to be more events (greater than expected decline in Chinese economic activity; turmoil in the emerging markets and commodities; miscalculations by one or more central banks that would upset markets; a potential escalation of violence in the Middle East) that could lower those assumptions than raise them.  That said, our Model’s current calculated Fair Values under the best assumptions are so far below current valuations that a simple process of mean reversion is all that is necessary to bring Market prices down significantly.

I can’t emphasize strongly enough that I believe that the key investment strategy today is to take advantage of any further bounce in stock prices to sell any stock that has been a disappointment or no longer fits your investment criteria and to trim the holding of any stock that has doubled or more in price.

Bear in mind, this is not a recommendation to run for the hills.  Our Portfolios are still 55-60% invested; but their cash position is a function of individual stocks either hitting their Sell Half Prices or their underlying company failing to meet the requisite minimum financial criteria needed for inclusion in our Universe.
            Thoughts from a bull (medium):

DJIA             S&P

Current 2015 Year End Fair Value*              12300             1525
Fair Value as of 10/31/15                                12234            1517
Close this week                                               17215            2033

Over Valuation vs. 10/31 Close
              5% overvalued                                12845                1592
            10% overvalued                                13457               1668 
            15% overvalued                                14069                1744
            20% overvalued                                14680                1820   
            25% overvalued                                  15292              1896   
            30% overvalued                                  15904              1972
            35% overvalued                                  16515              2047
            40% overvalued                                  17127              2123
            45% overvalued                                  17739              2199

Under Valuation vs. 10/31 Close
            5% undervalued                             11622                    1441
10%undervalued                            11016                   1365   
15%undervalued                            10398                   1289

* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term   cyclical influences.  The model is now accounting for somewhat below average secular growth for the next 3 to 5 years. 

The Portfolios and Buy Lists are up to date.

Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973.  His 47 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies.  Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.

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